Wednesday, October 24, 2012

Algorithms, Arbitrage, and Overreaction on Intrade

There were some startling price movements in the presidential contracts on Intrade yesterday. Here's the price and volume chart for the Romney contract, which pays out $10 if he is elected and nothing otherwise:

At 7:52am the price of this contract stood at 40 (this is a percentage of the contract face value, so represents $4.00). Over the next two hours the price edged up to 42, with about 4500 contracts traded. That's where things stood at 9:58. Over the next three minutes the price rose sharply to 48.5, with a further 1700 contracts traded. This was followed by sharp oscillating movements between the peak and 42, which can be seen as the red blur at around 10am in the chart. By 10:15 the price had fallen to 43 and the oscillations had mostly ceased. An hour later the price was back down to 41, with about 14,000 contracts and $63,000 having changed hands over three hours.

What caused this unusual price behavior? There's been some talk of attempted price manipulation, but I have my doubts because the trader who was buying aggressively over this period was extremely naive. (I am fairly certain that this was a single trader). Throughout the buying frenzy, the Obama contract never fell below 57 and there was a substantial block of bids at or above this price. The trader who was buying Romney at 48 could have made the same bet for 43 by simply selling the Obama contract at 57. In fact, he would have obtained a slightly superior contract, which would pay off if any person other than Obama were to win, including but not limited to Romney.

This fact also explains the oscillations in the Romney price, and the decline to 57 under selling pressure of the Obama price. Any individual who had posted ask prices in the 43-48 range in the Romney market had these orders met by the crazed buyer, and could then sell Obama above 57 for an immediate arbitrage profit. As it happens, there are algorithms active on Intrade that do precisely this. They post ask prices that, together with with highest bid in the complementary contract, add up to slightly more than 100. As soon as these orders trade, they sell the complementary contract at once, booking a riskless profit. These algorithms posted prices in the 42-43 range over the period in question, and the buyer repeatedly traded through them to reach the higher Romney asks. Hence the red blur in the chart. Only when the buyer gave up or ran out of funds did the price settle down.

If this was not an instance of attempted manipulation, then what was it? I suspect that it was an overzealous response to reports of a major announcement concerning the presidential race, promised by Donald Trump. Further frenzied activity in the presidential and state level markets took place in the evening, as speculation about the nature of the announcement started to spread.

This whole bizarre episode tells us very little about the presidential race, but does shed some light on how these markets work. Changes in one market spill over instantaneously to changes in linked markets via arbitrage, some of it executed algorithmically. And algorithms that work very effectively when rare can end up with disastrous results if copied. For instance, if two algorithms were to follow the strategy outlined above, it is possible that only one of them may be able to complete the second sale since the first mover would have snapped up the existing bids. This kind of game is currently being played in the world of high frequency trading, but with much higher stakes and considerably more serious economic consequences.